Dangerous liaisons

Assistant Proffesor, Stockholm School of Economics and Baltic International Center for Economic Policy Studies

De jure, we have embraced the Western tradition, which sees the state manily as a service provider, but de facto our minds are still loyal to the concept of the state conceived by Lenin, the state designed to enslave and exploit the individuals.

Is Latvia a democracy? This is a very hard question, but let’s consider two intuitively simple, yet very different, views of how things work in this country. Those who believe that Latvia is clearly a democracy would begin by pointing to the fact that voters elect their representatives into the Saeima [parliament], which appoints the government. They will also point out that, if voters are unhappy with the government, or the Saeima, they will vote it down in the next election. This, the argument goes, will ensure that elected representatives (wishing to be re-elected) will, most of the time, act in the interests of voters.

In recent years, however, there has been an increasing amount of questioning of whether the above is an accurate description of how things really work in Latvia. Some critically-minded people argued that, although politicians are elected by the voters, they mostly cater to the interests of small but well-organized business groups. They do so by using their legislative and executive powers to protect the business interests of these groups, and create profit opportunities for them. When the election time comes, business groups use these profits to finance expensive election campaigns that help these politicians to get re-elected. Thus, according to this more pessimistic view, Latvia may be a democracy de jure, but de facto it looks more like some sort of oligarchy.

I have to admit from the start that I do not have the answer to the important question of whether Latvia is a democracy de facto as well as de jure. However, I believe I can demonstrate evidence that will shed some light on the above issues. My focus is on a rather narrow question of whether political connections matter to the performance of firms. For example, does making a campaign contribution make firms grow faster compared to similar firms that made no contributions? In a well-functioning democracy, political connections should not matter to the performance of individual firms because most voters would not be happy with the idea that politicians use their office for the profit of some businessmen. Political parties usually do not admit there is a quid pro quo relationship between them and people who finance their election campaigns. What we are typically told is that contributions are simply a token of support for a party’s program, pretty much the same as voting. In a de facto oligarchy, however, campaign contributions are part of the implicit agreement between politicians and business interests.

In what follows I will demonstrate convincing evidence that political connections do matter and, specifically, campaign contributions result in benefits to the firms that make them. I will also attempt to put these findings in a broader picture by discussing the consequences and the causes of connections.

Before I go on, however, a likely objection has to be addressed. “So what?” – a critical reader may ask. There is plenty of evidence of corrupt politicians and their links with businesses, isn’t there? That is certainly true; there is no shortage of such stories in the newspapers. This, however, is anecdotal evidence, and this kind of evidence can never be fully convincing. We know instances when politicians are corrupt and we know instances when they are not. The important question is whether corruption is an exception rather than the rule? Or, is it the other way round? In other words, what we need to know is whether an average firm benefits from being politically connected, and this is precisely the kind of evidence I aim to deliver.

Do Political Connections Matter?

One has to begin with a clear definition of ‘political connections’. In my research[1] I look at two kinds of connections. First, I consider any company that contributed to a political party directly, or through its shareholders or board members, to be politically connected. For reasons that will be explained later, I focus on the 2002 national election cycle. Second, any company with a politician, or an ex-politician among its shareholders or board members is also considered to be politically connected. Henceforth politicians are meant to be members of Saeima and/or ministers. I look at all companies and politicians in the 1996-2005 period.[2] My measure of firm performance is annual growth in total sales.[3]

The methodology is as follows.[4] I begin with using the Lursoft database to identify all active firms that are politically connected using the above criteria. Thus, I identify 844 firms connected by making campaign contributions in the 2002 election cycle.[5] Note that only 188 of those contributed directly (i.e. as firms), whereas all others did so through their shareholders or board members. Furthermore, I identify 554 firms connected to 259 politicians (or ex-politicians). As a point of reference, note that, since regaining independence, there have been a total of 527 national-level politicians. Then, each connected firm is matched to a similar non-connected firm of similar size (measured by assets) and in the same industry. Thus, a control group is formed which can be used for making comparisons between politically connected firms and similar non-connected firms. In case of campaign contributions, for instance, such a simple comparison reveals that sales growth of connected firms was nearly twice as high as compared with non-connected firms.[6] I find that average sales growth rate of donors in 2002 elections was 8%, whereas average sales growth of similar non-connected firms was 4.3%. For firms connected to politicians, I find that their average growth rate is 50 percent higher compared with similar non-connected firms.

At this point a critical reader is likely to object by pointing out that “correlation does not imply causality”, that there are other factors which might be responsible for this result. For example, connected firms might have smarter managers and, therefore, be both successful and politically active. Or, perhaps, causality goes in the other direction, so that successful firms give campaign contributions, presumably because they can afford it. The confounding influences can, to a large degree, be controlled for using rigorous regression techniques. The detailed methodology will not be discussed here but can be found in the original research paper. Figuring out whether political connections have a causal effect on the performance of firms is quite tricky. One of the ways is to find an unanticipated external event that would affect connections. Consider a more intuitive example of electricity, which we know is an important factor of production for most firms. Inferring its importance by simply looking at firm performance and consumption of electricity is a hard task. However, if the lights unexpectedly go out i.e. there is a blackout, this will give us a fairly good idea of the importance of energy supply.

I argue that there was one instance when the ‘lights went out’ in Latvian politics – when the Latvia's Way (Latvijas ceļš) party did not get re-elected in 2002. The Latvia's Way played a very special role in Latvian politics. I think there is a fair chance that future historians will call the 1991-2002 period the ‘era of the Latvia's Way’. It was in every one of the nine ruling coalitions in this period. It held the prime minister’s office for most of the period. There is little doubt that its political influence was enormous. Yet in 2002 election it fell 0.1 percent short of the 5 percent barrier. This was unexpected as most of 2002 the polls predicted that the Latvia's Way would get in the Saeima. Another surprise was the First Party of Latvia(Latvijas Pirmā partija), which got 9.5 percent of the vote, although the polls predicted in would not get elected. Needless to say, businesses affiliated with the Latvia's Way were in for a nasty surprise.

I find that a firm lost 2.9% of sales in 2003 for every 1,000 Ls that it gave to the Latvia's Way, controlling for other factors. Thus, an average donor to Latvia's Way, who gave 6.8 thousands lats, lost nearly 20 percent of sales in the post-election year. This is not a small amount, as its average sales in 2002 were nearly 1.4 million Ls. In contrast, a firm gained 2.8% of sales in 2003 for every 1,000 Ls that it gave to the First Party, controlling for other factors. Because an average contribution to the First Party was larger (12.2 thousands Ls), this implies a 34% increase in sales in 2003. For reference, average 2002 sales of a firm that contributed to First Party was about 803 thousands lats. This presents formidable evidence that political connections matter.[7] If the firms, and their board members and shareholders, contributed merely to ‘support’ their candidates, the election outcome should not have had such a strong effect on sales.

The Consequences

If one accepts that political connections matter, the question is what it means to us, the people of this country. Some may argue that the fact that politicians actually provide benefits to some businesses is not such a bad thing. Perhaps, but it depends on how businesses benefit from political connections. It is a mistake to think that what’s good for business is good for a country. The main motive of entrepreneurs is profit. They can achieve it in a way that benefits the society – e.g. by innovating, producing goods and services and competing to deliver the best value for money to their customers. However, they also do not hesitate to profit from securing monopoly power, getting rid of the competition, blocking entry of new businesses to their market – if they can get away with it. Profit seeking has its ‘dark side’. How can businesses profit with the help of politicians and what are the consequences?

First, obviously there are plenty of opportunities to fiddle with state procurement. We can suspect that what public sector buys is more expensive than it should have been, and sometimes should not have been bought in the first place. Second, connections (e.g. campaign contributions) could be a down payment to receive some services in the future. For example, some recent events suggest that it is hard to build anything in the city of Riga without bribing officials of the city Council. Perhaps those who help elect the winning parties with their contributions get a discount. The above examples have been much discussed already and their interpretation is simple. Both cases are instances of theft, and we are its victims. For example, if it takes a large bribe to obtain a permit to construct a new apartment complex in Riga, construction firms will treat it as an expense of doing business, and pass it on to us, the consumers, in the form of higher prices. Clearly, what makes this theft special is the ignorance of victims, who often do not realize their pockets have been skillfully picked.

There is a third way of how businesses can profit from political connections and it is the worst one. Politicians use their office to create monopoly power – by creating barriers to entry, making life difficult for competitors, and often simply by consistently favoring connected firms. Economists have called it the production of rents. Unfortunately, one does not have to look far for examples. Take recent actions by municipal governments, which would effectively create regional monopolies in garbage collection. Monopoly power means large profits, and high prices. Moreover, in time such interaction between politicians and businesses will result in an economy where most firms operate in well-defined niches, protected by nuanced regulations and the power of their partners in politics. In other words, we will see creation of a de facto oligarchy in a de jure democracy. There will be no innovations, no prosperity. The best and the brightest will flee to other countries, leaving mostly the new plutocrats and those they can fool and exploit. What has been happening in Russia in the last years is a good example of this.

The Causes

If you agree that political connections are a concern, the natural question is what can be done about it. There is no shortage of proposals as to how to put an end to corruption but many of them are of the “forbid-and-forget” variety. For example, there are proposals to outlaw campaign contributions from private individuals and finance election campaigns exclusively from the state budget. I have serious reservations about the effectiveness of such naïve solutions. In the example with campaign contributions, firms were forbidden to make contributions but effectively continued to do so through persons connected with them, e.g. its board members and shareholders. Or, take the recent controversy with the election campaign of the People’s Party (Tautas partija). Where does freedom of speech end and political campaigning begin? I am skeptical of the effectiveness of simple ‘solutions’ because they go after symptoms one can readily observe, but do not address the underlying causes of the problem.

What are the causes? The essence of the problem can be sketched in the following way. Businesses seek profits. Politicians and public officials can provide profits to businesses by conferring monopoly power in sophisticated, hard-to-observe ways – if they can get away with it when election comes. In turn, businesses can use part of their new profits to finance ‘brain-washing’ election campaigns for the politicians that help them. As a result, the state is captured by special interest groups, and democracy is subverted. Unfortunately, there is no simple solution to this problem. There is no magic switch, no legal act that can forbid something, no money that can be given to somebody to make things right. Yet a number of issues follow from the above and I will discuss them briefly.

Cause #1: Worship of the ‘state’

It is a sad legacy of our Soviet past that we look up to the state as if it were some sort of divine entity, which ought to be present in all areas of people’s lives, attempt to solve all problems that arise. This is in great contrast with the Western liberal tradition, which sees the state as mainly the service provider for the free people: “the government of the people, by the people, for the people”. De jure, we have embraced the Western tradition, but de facto our minds are still loyal to the concept of the state, which was conceived by Lenin and the likes, the state designed to enslave and exploit the individual. As a result, there is a widespread confusion about our relationship with the ‘state’. Unfortunately, most people do not seem to realize that the ‘state’ is not a divine entity but an institution that is run by people, who have their weaknesses. An important consequence of this confusion is that too much power is vested in the state.

Consider an example with traffic police. Ordinary policemen are paid very little (about 300-400 Ls) but they wield substantial power on the road. One of these powers is that they seem to enjoy quite a lot of freedom in how they enforce traffic regulations. They are seldom engaged in patrolling the streets, which is effective from the viewpoint of enforcing regulations but not very profitable. Police usually hides in locations where drivers are likely to break the rules. This is certainly a profit (bribe) maximizing strategy – some accounts suggest that daily revenue from taking bribes is about the same as official monthly salary. Part of the explanation is that the police is run in a way that policemen have too much power to conduct their business as they please, and so they choose lots of ‘hiding’ and little patrolling.

Cause #2: Ethnic Division

One of unwritten rules of Latvian politics is the ‘100-X’ rule, which states that the process of coalition formation begins by subtracting X, the number of seats in the Saeima that belongs to the ‘Russian’ parties. Due to historical reasons, ethnic Latvian majority has a grudge against and the Russian-speaking minority, maybe for good reason. The majority consistently makes sure that the minority pays its taxes but has no voice in how the government is run. It is a sad fact that most ethnic Latvians explicitly or implicitly vote to ‘keep the Russians out’ and the political parties are only happy to oblige. If a large part of population genuinely enjoys disenfranchising another part of population on ethnic grounds, there really isn’t much that can be done about it. However, those who take pleasure in ‘keeping the Russians out’ should be aware that this is done at a price.

Voting does not work very well when there are many issues at stake, especially when some issues are very sensitive. Simply put, people who vote to keep the Russians out forego the opportunity to vote for good kinder-gardens. Corrupt politicians also benefit enormously from ethnic divisions. If voting didn’t break along ethnic lines, perhaps anti-corruption election platforms would garner more votes than they do now. Sometimes the efforts to conceal true motives behind the ‘keeping the Russians out’ slogan border on the absurd. For example, whenever someone is critical about People’s Party’s expensive Palace of Light national library project, he is labeled “anti-Latvian” and accused of acting in “Moscow’s interests”.

Cause #3: Voters’ Human Capital

It is an old maxim that every people get the government they deserve. Politicians find suspicious partnerships with businesses attractive only in so far as they can get away with it in the elections. And they can only get away with it if the voters are uneducated, ignorant, and disinterested in what is going on. If the mass of voters is content with being ruled, without questioning the rule, de jure ‘democracy’ is the best deal they are ever going to get.
___________________________

[1] Vyacheslav Dombrovsky, "Political Connections and Firm Performance: The Latvian Way", Stockholm School of Economics and Baltic International Centre for Economic Policy Studies

[2] For the exception of banks, state-owned companies, and non-profits organizations.

[3] Any measure of performance based on reported profits would certainly be suspect because of widespread perception of tax evasion.

[4] See the accompanying paper for more details on research methodology.

[5] January 1st to October 5, 2002.

[6] Average in this case (and in the next example) refers to the median and is calculated over all years.

[7] Please see the original paper for some other interesting findings on the effects of political connections.